Thursday, February 26, 2015

Ok, one more graph on the timing of the crisis. Here we can see the problem of inflation targeting.

There has been some discussion about how commodity prices bumped up in 2007 & 2008, which caused the Fed to be too hawkish. And, I have discussed how current inflation is negligible, but for supply-shock shelter inflation. But, I think we can step back even further, and see this problem even earlier.

I have looked at the period around 3Q 2006, when the yield curve inverted. But, let's look even further back, to 2Q 2006 (0b), or even 4Q 2005 (0a). Even before the yield curve inverts, we can see that liquidity is having an effect on the housing supply. (Remember that currency growth, which has tended to be between 7% and 10% since the 1970's, fell under 5% by 2005.) By 4Q 2005, shelter inflation took a sharp turn upward. This was a monetary-related supply shock. Because everyone was so thrown off by high nominal home prices, this seems implausible. But, if we pull shelter out of the inflation indicators, we see that non-shelter inflation collapsed by 4Q 2006, with Core CPI less Shelter falling all the way to 0.7%. Core CPI with Shelter included was still at 2.1%! Seemingly above target.

Keep in mind that shelter inflation takes a 3 sigma turn upward between time 0a and 0b when we look at the next graph. (It is normally a fairly stable measure, like Core CPI is.) While shelter inflation is soaring, home prices are stagnating and new home supply is collapsing. How can this be interpreted as anything other than a massive supply shock? And this all happened before 3Q 2006! But, because the narrative of predatory, reckless banks is more believable than the mathematical relationship between yields and prices, nobody can believe this was the case.

Note here that currency growth falls in 3Q 2006 also, and will remain around 2% until 2008. So, keeping all of these things in mind, we can think about mortgage growth, shown in this graph. At this point, mortgage growth isn't funding new homes anymore. It's not funding home price appreciation any more. At this point, mortgage debt has become a source of desperation liquidity. Mortgage levels as a percentage of home values turned up sharply by around Q1-Q2 2006. As I showed in Part 12, this liquidity coming through mortgages between 2004 and 2007 all came from households in the top 40% of incomes. Households in the bottom 60% of the income distribution were not increasing their outstanding mortgages during this period.

It looks to me like the Fed created its own supply-side inflation shock, then mistook that for a positive demand shock, and subsequently worsened what was already a negative demand shock. But, can we blame the Fed when the entire country is seemingly wrong about housing?

I am hoping that I can make some inferences about tax benefits of home ownership and the relative supply of housing in later posts.

A couple more graphs regarding the shape of the mortgage market during the housing boom.

Here, I have estimated the income levels of the family holding the median dollar of mortgage debt, the median net new dollar of mortgage debt, and the median homeowner.

As with earlier summaries I have done of the Survey of Consumer Finances, these measures also show that new mortgages were not going to lower income households during the boom. The income percentile of the average homeowner was roughly flat throughout the period, and mortgages went to families with slightly higher incomes in the 2000s compared to the late 1990s.

You can think of the median mortgage holder measures I am using here in this way. Imagine that the banks line up all of the dollars they have lent out in mortgages, in order, by the incomes of the debtor families. Then they start counting up, until they have counted half of the total. These measures are the measures of the income level of the family that holds that mortgage.

Interestingly, while the median income of home owners didn't decrease between 1992 and 1998, during the time when the CRA might be credited with expanding home ownership, but before home prices began to rise, the median income of mortgage holders did decrease. During this period, homeownership increased across incomes (slightly more among high incomes). But low income households did tend to buy relatively more expensive homes.

The two years where the median holders of net new mortgages are out of whack here are 1995 and 2010. That's because in 1995, high income families were reducing their mortgage debt while low incomes families were increasing it.

In 2013, families were reducing their mortgage debt, and this was especially pronounced in low income families (presumably because many lost their homes in the aftermath of the crisis). So, the low median income of the net mortgage loser has caused the median income of the remaining mortgage holders to rise.

This is not a picture, during the boom, of low income families being herded into large mortgages. This is the picture of a fairly normal real estate market.

The 1990s and 2000s follow reasonable patterns of real estate investment, across incomes, whether in terms of total cash payments as a proportion of income or as compared to alternative fixed income investments outside of real estate (see previous posts in this series). The picture of haves and have-nots comes in 2013, where only high income families can enter the mortgage market, and those that can enter, earn extremely high returns, in terms of (rent value / home price). These are classic excess returns due to exclusivity, which are increased even more, by the way, by friendly tax policies. (Although, one should not forget that most of these homeowners were dealt a large unrealized capital loss after 2006.)

This problem was mostly created by disastrous Fed monetary policy and by pro-cyclical bank regulations. It would be solved by less volatile monetary policy (NGDP level targeting is a good place to start), the elimination of pro-owner and pro-borrower tax policies (which, because of the substantial value of untaxed imputed rent, can probably only be fully eliminated by eliminating capital and corporate taxation), and less cyclical regulatory meddling.

Is there anyone pushing to solve this problem with more regulation who has even stated an understanding of the relationship between prices and rents, and how universal access, liquidity, and fairness would have to be associated with significantly higher home prices? Price = Income / Yield. We're not going to move these measures by changing rents. Rents are pretty stable. The only way to keep prices down is to keep yields up. The only way to keep yields up is to make an exclusive, non-arbitrageable market. That is our current policy.

If you're complaining the home prices are too high, you're not helping.
If you're complaining that we're not being punitive enough with the banks, you're not helping.
If you're complaining about speculators in the housing market, you're not helping.

As with the previous posts, here again we see credit and pricing pressures first, followed by rising delinquency. (Here is a set of slides from the Richmond Fed, with delinquency broken out by mortgage type. It looks like the same story to me. Subprime delinquencies are higher in general than other mortgage types. But, it looks to me like all mortgage types had delinquency rates that crossed above the previous average levels in about 2Q 2007.)

Loan to Value was rising during this period, but FICO scores remained stable, even on (pdf) subprime loans. Low equity could plausibly lead to more systemic risk in a downturn. On the other hand, by 3Q 2008, home prices had already declined by more than 20%, so even a 20% down payment would not have served as full insurance. And, even by then, delinquency rates were less than halfway to their eventual peaks.

The same Federal Reserve paper that mentions the FICO scores also notes that investor buying didn't appear to accelerate as a proportion of subprime & Alt-A loans in the 2005-2006 period. That is surprising to me after my findings from the Survey of Consumer Finance data. But, we should keep in mind that these loans were increasing as a proportion of all mortgages, so investor mortgages as a proportion of all mortgages would have been rising strongly. These loans are also more likely to engage in a tactical default if property values fall.

So, we have 3Q 2006, when the Fed finishes hiking the Fed Funds Rate, but pegs it at a level even higher than long term rates, which, according to a well-known Fed model, is a yield curve characteristic that tends to portend recessions. In the same quarter, mortgage loan growth begins to sharply slow, and home price growth turns negative.

The next quarter, banks report tightening standards on mortgages. (The graph is a little messy because the bank lender series were re-categorized in 2007.)

Then, in 2Q 2007, delinquencies rise above the average for the previous decade for the first time. The rise in delinquencies is a mirror image of the decline in home prices.

I have included Banking standards on Consumer Loans in the graph, too. This is one indicator that does tend to lag the problems in the home market. I would have pointed it out as evidence in favor of my narrative if it had led or been concurrent with the housing indicators. But, it didn't. So, I can't.

But, generally, I consider this to be more evidence in defiance of the narrative that default rates on toxic mortgages to low income homeowners who couldn't make the payments were the causal factor here.

Wednesday, February 25, 2015

Well, I was hoping that the lighter touch from regulators announced late last year would lead to a V-shaped recovery in real estate credit. There has been a slight shift. Closed-end real estate loans held at the banks had been declining at a pace of about 4% annualized since the taper had wound down. And, it looks like this has turned around to a growth rate of about 2% over the past few months. That's a total change in trend of about 6%. But, between QE2 and QE3, mortgages at the banks were growing by 6%, so I would have thought we could reach a growth rate higher than that.

If the turnaround in mortgage credit has a long, slow buildup, the natural recovery of market interest rates will be slow. I think we really need to see mortgage levels growing by 10% or more for several years in order to get homes back to intrinsic values, and to serve as an outlet for all the excess savings that has been left without an investment outlet since 2007.

Home equity lines continue their slow descent, too, which also suggests that we haven't hit any sort of regime change in the credit markets yet. From a speculative point of view, if this is how it's going to play out, I guess the best hope is for the Fed to call off the dogs and leave rates at 0.25% longer than expected, which would cause a pull back in intermediate rates. Once the mortgage market gets its feet under it again, there should be a virtuous cycle of real production growth and credit growth that would cause an acceleration in the recovery, and in the recovery of forward interest rates. Maybe, in 9 months or so, June 2017 Eurodollar contracts could be sold at 98.5, and bought back a year later at 97 or less.

As things are proceeding now, though, until then, I'm afraid the forward interest rate market is just muddy water. If the Fed does go ahead with rate hikes before mortgages gain steam, I think they might be able to push up to 1% or 2% without doing much damage to the short term non-real estate economy. I'm not sure there would be a clear position to take on the way up, and I don't know how confident I would be about the timing of the ride back down that would come if/when they tighten too much.

Tuesday, February 24, 2015

I have been outlining data from the Survey of Consumer Finances to double check the story that the bank delinquency data seems to tell, that the widely believed story about the housing boom and the recession is based on evidence that is much more flimsy than we might have thought. In the previous post, I introduced data from the SCF that showed how the growth in homeownership came from high income households and that households didn't increase their debt payment/income ratios or their relative consumption of housing during the boom. The evidence against the standard narrative is even more stark when we look at dollar levels, because, despite frequent implications to the contrary, low income households don't tend to take on nearly as much debt as high income households.

(In fact, the normal relationship is overwhelming. Higher debt is associated with higher incomes, whether comparing over time, comparing cross-sections of a population, or comparing across nations. When we hear a story about desperate American households accumulating debt just to keep their heads above water, our BS sensors should go up. We should be thinking, "That contradicts practically everything we know." I think this is from a confusion between thinking of states of disequilibrium and states of equilibrium. We think of our own lives, and the times that are memorable to us are times where something went wrong, and we took drastic measures that might be unsustainable without some good fortune. So, we remember that time when we lost our job, and we ended up with $15,000 on our credit card, and wondered how we'd ever get our life back in order. But, we don't think about the fact that, 10 years later, when we were pulling in $100,000 a year, we took out a $200,000 mortgage. Even within an individual life with periods of upheaval, the correlation between debt and economic success is massive. The story that says an entire economy has been in a constant state of disequilibrium for decades is highly suspect. Especially when it coincides with a massive bidding war on the most fundamental middle class asset.)

To the charts!

The first chart shows the mean level of debt per household, by income level. In 1989, the average household held about $32,000 in mortgages. By 2007, this had risen to about $82,000. But this debt is overwhelmingly held by high income households.

The second chart makes this even more clear. This is a measure of the total level of mortgage debt in the US. The top 20% have never held less than 50% of total mortgage debt. The top 40% have held roughly 80% of mortgage debt throughout this period. From 1992 to 2013, the bottom 40%of households held 7-10% of mortgages outstanding. In 2007, this amounted to $857 billion out of a mortgage market worth nearly $11 trillion.

Keep in mind, the homeownership rate has been over 64% since the 1960's. The homeownership rate of the bottom 20% of households has floated around 40%, and the 20-40% quintile has a homeownership rate over 50%. So, this bottom 40% represents more than a quarter of all homeowners, and has for decades. They just don't have much mortgage debt.

There are widely read authors - many, in fact - who claim that (1) the gains in the economy have been going to the "top 1%", and who also claim that (2) the reason the economy failed is because low income households have been living on massive levels of debt, just to get by. They claim that the economy finally toppled due to the unsustainability of that process.

How could they be so wrong? Let's forgive for a moment that those frightening graphs of rising household debt are showing debt that is 80% held by the top 40% of households. Maybe low income households don't have high debt levels in absolute value, but maybe they are high compared to their own incomes.

Yesterday's post included this graph of debt payment / income ratios. For 24 years, debt payments look pretty manageable and stable.

Here is a graph of total debt / income. Aggregation is always dangerous, and here, for instance, we know that the aggregation within income quintiles hides the difference in leverage between renting and owning households. But, that being said, mostly what is striking to me here is how uniform debt/income ratios are throughout the income ranges. Debt levels did rise somewhat over the first 12 years, then they did rise quite sharply in 2004, concurrent with the sharp rise in home prices. Then, they remained high after the crash. But, the pattern is very similar among the entire bottom 90% (except for the bottom 20% after the crash, which is probably an artifact of formerly high income families moving down the income scale). Are we to believe that 80-90% percentile households, with incomes over $100,000, are exhibiting the same distressed debt accumulation as the bottom 20%? And, if this debt is a product of distress, how in the world does that result in a tripling of home prices over the course of a decade?

As I have argued before, the anchoring of real estate value on the future value of expected rents means that when long term interest rates decline, nominal home values must rise. There is no way that households could have held debt levels steady in this environment. And, the stability of debt payments is a signal of this issue. The increase in debt is all mortgage-based. There is some rise in non-mortgage debt in the bottom 40%, but some of the same issues could be at play to a lesser extent regarding other debt secured by durables, such as auto loans.

But, let's not lose sight of the broader problem here, the notion that mortgages which were pushed on low income households created a systemic crisis.

This next graph shows the net additional mortgage debt held by households, disaggregated by household income quintile, with 1992 as a baseline. For instance, in 1992, the average bottom quintile household held $4,500 in mortgage debt. By 2007, they held $12,500 in mortgage debt, a net gain of $8,000 per household (in 2013 dollars). In total, households in the lowest quintile held $185 billion in net extra mortgage debt by 2007. The second quintile held $324 billion in extra mortgage debt. These together represents 9% of the new mortgage debt. 77% of the new debt over that time went to the top 40% of households.

So, if every single net new mortgage debt issued to the bottom 40% of the income distribution had defaulted, the total value of the losses, before recovery, would have been $324 billion. Keep in mind that homeownership rates did not rise among these income groups during the boom, and that this income group had stable home ownership rates for decades before this.

Homeownership rates did rise for the median income quintile, from about 62% to 72%. If every single net new dollar loaned to them during this period defaulted, that would amount to $833 billion before recovery.

What if the entire bottom 60% of the income distribution had sub-prime level 10% default rates on these net new mortgages. That's a loss of $116 billion before recovery. In dollar terms, that's 1.1% of mortgages outstanding.

The bottom 60% of the income distribution represents about 1/2 of all homeowners. At the highpoint, subprime mortgages were around 20% of originations, reaching more than $600 billion per year. That is almost the entire level of mortgages outstanding for households in the bottom 40% of incomes. If every single mortgage origination going to the bottom 60% of households, by income, was subprime, it would have been a small share of subprime loans.

Between 2001 and 2007, when subprime originations increased from $173 billion to over $600 billion each year, total mortgages to the entire bottom 60% only increased by $908 billion over the entire period. Mortgages to the top 40% (all with incomes over $100,000 $85,000 per year in 2013 dollars), increased by $3,527. Mortgages to the top 40% didn't just increase more in absolute terms; they increased at a faster rate than low income mortgages.

There simply isn't any way that more than a small handful of subprime loans were going to low income households. And, here, again, it's useful to look at the timing of events. Here is a graph from this St. Louis Fed summary of mortgage originations.

Think about the timing here. Short term rates were rising by 2004. The proportion of subprime and Alt-A loans was still very low in 2003. There weren't that many subprime loans originated when rates were low. Subprime and Alt-A originations were increasingat high interest rates. More than $2 trillion worth of these loans were originated at higher rates.

As the St. Louis Fed points out, many of these loans were for investment homes. Here is a graph of mortgages for non-Primary residential real estate. These subprime loans were going to the top 10% of households.

Thousands of 2013 $, per household

Next is a graph of non-primary residential mortgages, by age. (Some of the 75+ group movement could be affected by outliers with small sample sizes.) These loans were funding investments by high income baby boomer professionals who were lining up long-term low-risk income for their retirement. Even in 2004, homes were a good alternative to bonds. Even now, with all that has happened, those homes over a 20 or 30 year period will earn decent income for their owners who held on to them.

In the aggregate, this is not a story of poor workers duped into overpriced homes with toxic mortgages. This is a story, mostly, of very wealthy, very high income individuals making reasonable investments, given their alternatives, and then, after the nominal values of those assets were impaired, making the decision to put them on the banks, which again, given their alternatives, was reasonable. Along with that, a wave of unemployment caused by the dislocation drove more Americans out of their homes because of income shocks.

Here is an estimate of homeowner equity. (I show the equivalent measure from the Fed's Flow of Funds report. It has a similar pattern, but with lower equity. The debt levels from both sources are similar, since they are easily documented. The difference appears to come from what survey takers think their own homes are worth versus what a grumpy economist at the Fed thinks it's worth. The truth is probably closer to the Flow of Funds number, but the patterns should be similar.) Equity did fall (leverage rose) from 1989 to 1992, then generally leveled off until the crash destroyed home values. But, note that low income households tend to have very low leverage, because they are mainly divided between renters with no mortgage debt and retirees with years of equity. Typical leverage levels increase as income increases. The mortgage interest deduction might have a lot to do with this. Someday, I'd like to see if this differs from the pre-1986 period.

Here, we see the net new mortgage debt, averaged per household. In 2007, the median household ($47,000 annual income) had seen their mortgage grow by $36,000 while their home's nominal value had grown by $74,000 over 15 years (in 2013 dollars).

In this last graph, I think we have a window into the distributional effects of housing tax benefits. Over time, to the extent that I can estimate the portion of home price appreciation that can be explained with tax policies, the distribution of the change in real estate values provides a sort of present value of future tax savings. And, the distribution of real estate capital gains suggests that these benefits skew extremely toward high income households. They simply hold much more real estate and much more debt than other households do. This value would represent taxes saved. At the other end of the spectrum, taxes on real estate without those benefits are paid by tenants, embedded in higher rents, and paid to the government through their landlords.

How Can We Be So Wrong

If you have an epileptic fit, and there happens to be a witch in the room, it really, really seems like the witch is the culprit. The American public was convinced that homes and mortgages were a problem before the crisis even began. The same political zeitgeist that led to the Fed's disastrous policy already had its scapegoats built in. The tight money policy itself was a product of distrust of the housing and mortgage industry. Yes, there were shady characters out there. There were financiers who were too aggressive. There were bureaucrats pushing dangerous programs. There were investors using specious logic. There were traders who thought the traders on the other side of the deal were making a bad trade. (Can you imagine?!) But, there are always all of these characters, in every industry, every walk of life, in good times and in bad times. The reason we have the narrative we have is because bankers are today's witches. If a banker is in the room, you don't need to confirm the connection. We all know bankers cause crises. What is there to prove? And, once you are there, it is really easy to blame a financialcrisis, of all things, on them. The dots practically connect themselves. There are plenty of anecdotes and empirical data to build a satisfying, if careless, narrative. And being careless is the easiest thing in the world to do. (Added: Even if the witch is in the corner, doing incantations about seizures, that is still not evidence that the witch caused the seizures. But, if you believe that witchcraft is a powerful problem, you will have a very hard time accepting this caveat. This error is central to the human condition and to the greater part of human existence.)

Monday, February 23, 2015

I have suggested that the timeline of the recession does not point to subprime lending as the cause and that the scale of subprime lending was not sufficient to create a crisis. But, we don't have to guess about these things. The Federal Reserve has a nice history in the Survey of Consumer Finances.

First, regarding the Community Reinvestment Act, I have attributed the sharp upward trend starting in 1994 to changes in the CRA. But, I have noted that the growth in home prices didn't happen until several years later, after half of the increase in homeownership rates had already happened. So, CRA might have led to more homeownership, especially among lower income households, but that it doesn't seem to have contributed much to rising home prices.

﻿﻿﻿﻿﻿

note: the y-axis is not anchored at zero, in order to magnify changes.

Here is a graph of homeownership rates. (There is a jump in the lowest quintile from 1989 to 1992, but this appears anomalous to the present topic.) The growth in homeownership happens entirely above the 40% income percentile. This could mean that the CRA, despite the evidence of its importance among some mortgage originators, didn't really affect total mortgage originations, but simply shifted credit for them. Or, it could mean that there were large numbers of households in the top-half of the income scale who weren't being served by the mortgage market, and the CRA actually helped high income families buy homes.
This seems plausible to me. Retired households, households headed by adult students, and rural households in low cost-of-living areas should account for a large number of the bottom 40%. It could be that urban families who were the marginal homeowners affected by the CRA had middle-to-upper-middle class incomes, and that the high cost of urban property was an impediment to ownership for them. So, it could still be the case that the CRA was both (1) the cause of some of the rise in ownership and (2) not responsible for mortgage growth among low income households.

Whatever the case, the commonly repeated anecdotes of janitors and checkout clerks being
handed $300,000 mortgages on a hope and a prayer do not appear to be representative. On net, all the new mortgages went to families with incomes around $45,000 and higher. (Don't get me wrong. For the vast majority of new home buyers, this was a very profitable decision. If any low income households had bought homes too large for their budget in the 1990's, it would have paid off handsomely. Home prices are more than double what they were then.)

Here is the same chart, showing the total growth of homeownership, subdivided into income quintiles. From 1992 to 2004, homeownership grew from 64% to 69%. About 1.4% was from the top quintile, 1.4% from the 4th quintile, and about 1.9% from the middle quintile, even though most high income households already were homeowners. Additional homeowners would naturally tend to skew total ownership to lower incomes, but this was, surprisingly, notthe case in the 1990's and 2000's. Throughout that period, the average relative income level of homeowners was rising!

We see the same story in household debt. Debt payments were rising in the 1990's. But, in the 1990's, home prices were very low. And, furthermore, debt was rising both among owners and renters. In the late 1990's, debt payments rose among the 40%-80% income quintiles, which probably reflects the large increase in new homeowners among these households. But, I'm pretty sure that upper-middle-class households slightly increasing leverage to buy homes in a buyers' market is not widely considered to be a systemic problem. Also, note that the boom in home prices would first show up in the 2001 survey, and the 2007 survey should show the first signs of distress. During this period, there was no rise in debt payment levels. There is a distinct rise in debt payments in 2007 among 60%-90% income households. Then there is a distinct rise in <20% households in 2010. These are likely the result of households dealing with the aftermath of the crisis, first through upper-middle-class households drawing on home equity to make up for the currency shortfall (in 2007 - not in 2001 or 2004) and then, households who have been moved from high incomes to low incomes by the dislocations of the crisis in 2010.

Note that, even after the crisis reduced incomes across the board, families never had debt payment ratios as high as they had been in 1998 - neither owners nor renters.

The crisis did lead to dislocations among selected, unlucky, households. Here is a measure of the number of households who had debt payments amounting to more than 40% of income. Again, note that this level was rising in the 1990's - when homes were inexpensive. But, it was level in the 2000's - until 2007. And, notice that the rise is all coming from the top half of the income distribution.

So, we have seen an unsustainable debt-fueled economy. It happened in 2007, among high income households, after the Fed sucked the currency out of the economy.

Then, in the last chart, we see a measure of delinquency. Notice that delinquencies are flat for owners until 2010. They rise slightly for renters until 2004. Possibly that is due to the rise in interest rates. But, it is interesting that it is among renters, not homeowners.

Then, in 2010 and 2013, delinquencies rise among all household groups, across income groups (not shown), among owners and renters.

So, again, we find a shocking disconnect between the common narrative and reality. The narrative says that low income households were pressured into overpriced homes with oversized mortgages, until the inevitable end to the charade brought everything crashing down. First, the low income, subprime homeowners crashed, and then this led to a wider recession.

But, just as with the bank delinquency numbers, the story these household numbers tell is quite the opposite. As home values skyrocketed (I said, "home values") in the 2000's, households retained a very reasonable level of debt and debt payments. In the 1990's and 2000's, high income households were enticed into the housing market by the new higher value of homes (which I will argue through this series of posts was mostly a product of low long term interest rates and tax policy. In fact, the fact that high income households were the net homebuyers, is a predictable result of homeowner-friendly tax policies, since these are overwhelmingly utilized by high income households.) Then, as the Fed began implementing monetary austerity, high income households initially were able to counter the liquidity shock through credit expansion. But, when the Fed refused to relent, by late 2008, households did, and subsequently incomes fell across the board.

Finally, here are two graphs showing rent payments relative to incomes. Here, I have taken real incomes from SCF Table 1 and compared them to total rent paid by owners (imputed) and tenants, from BEA table 7.4.5 (adjusted by the GDP deflator and the census count of households). (Some care should be taken here, because of the mix of data. For instance, my inflation adjustment for rent is not the same as the inflation adjustment used for incomes.)

First, simply looking at real incomes, from SCF Table 1, we see that median incomes rose slowly until the crisis, while mean incomes rose quite sharply. This suggests that as we moved through the housing boom, the distribution of homeowners skewed more positively. In other words, the net new owners were unusually highincome households. And we see the opposite movement among renters. They began the period with a typical positive skew (a higher mean income than median), but as we moved through the boom, the median grew while the mean remained stable. This is because it was the highest income renters who were moving into homeownership, so the positive skew of renter income declined over this period (until the crisis reversed the trend, making many high income households renters again, or maybe more precisely turning high income owners into new low income renters).

Now, let's move to the rent to income measure. From 1995 to 2001 - even to 2007 - rent to income was decliningamong owners. In other words, owners were not moving into houses too large for their budgets; they were actually pulling back on real housing consumption as the boom matured. Much of this shift could be simply from the fact that the new owners tended to have higher incomes, and would naturally spend less of their income on rent. So, we see the mirror image in tenant rent/income. As the high income households moved from renters to owners, the remaining pool of renters tended to have higher rent/income ratios.

I also want to point to the change in rents since 2007. It has been level among owners but very high among renters. This is a complex issue, but I believe that as I work through the details in this series, I will show that both our owner-friendly tax policies, and the severe supply shock that has devastated the housing sector since 2007, create rent inflation that falls specifically on renters. Owners took a big hit through capital gains losses after 2005. But, the hit to real incomes has been much heavier on renters than on owners, mostly because tax policies and the supply shock create outsized inflation on tenant rental expenses.

The solutions to this problem are (1) to allow mortgage credit to flow and home prices to rise and (2) to eliminate taxes on capital. Don't hold your breath.

But, how to square this with the rise in subprime lending? I suspect that there isn't that much of a correlation between subprime and incomes. My mortgage wasn't "subprime", but I was self-employed with variable income. So, getting a conventional mortgage was especially hard, relative to what it should have been. How much of the subprime market was going to these kinds of households? Or high income households investing in second homes for rental income? I think it is plausible that the subprime boom was mostly related to high income households with unusual income profiles. They would have unusually high default risk, even though their incomes would be high. And, the added value (after tax) of homeownership in a tax-friendly, low interest context, would lead those households, reasonably, to take on the risk of leveraged home ownership.

Friday, February 20, 2015

2Q 2007: The reckless banks have finally pushed the subprime mess too far, and the damage is unavoidable. The Fed will do what it can, but it may be too much to deal with.
Home Price Index: 219
Delinquency Rate: 2.3%
Unemployment Rate: 4.5%
TTM Currency Growth: 2.0%
TTM Bank Credit Growth: 10.3%

It may seem like I'm trying to deny that there were some dislocations afoot in the housing market. There were clearly excesses in some cases, especially in some MBS toward the end. But, it's like we were crossing the street, and we tripped and cut our forehead on the pavement. It was a bad cut. It might have even needed stitches. Forehead cuts can bleed badly. It was disconcerting. But, while we were standing there, regarding our cut, we got hit by a bus. That bus is still barreling down the road, dragging us behind it. And, we're still saying, "Boy, that was one hell of a cut." Scale is what rules, and scale is about dollars, not provocative anecdotes. The anecdotes are provocative, and scale rules. Both.

Thursday, February 19, 2015

Considering the rhetoric surrounding the economy over the past 20 years or so, I am surprised at how normal the trends look in monetary and credit growth. I am not a monetary economist, so please comment if I make any important errors here.

I am using Loans and Leases in Bank Credit and Currency as my points of reference here. I realize that these aren't necessarily typical for this kind of discussion, but I think they more or less convey the information I am looking for. First, here is a long-term graph of the combined total of currency and credit. Since WW II, the growth of this quantity has followed fairly tightly with an 8% annual rate, falling slightly below trend in low inflation eras and growing slightly above trend in high inflation eras.

The second graph shows rent (both owner and tenant) as a percentage of GDP since 1929. I think what we are seeing here is that pre-WW II, less than 50% of households owned their homes. And, those who did own real estate mostly held it in equity. This was a cash-heavy economy. In 1947, there were about equal quantities of currency and loans & leases in bank credit!

I am not showing the graph here, but after WW II, there was a tremendous shift in the housing economy. Households gained access to mortgage credit, and many of them became home owners. Average Loan to Value moved from less than 30% even in 1952 to 45% in the mid-1960s. And, homeownership rates rose from less than 50% to the mid 60%'s over that time frame.

So, if we look at bank credit and currency, we find that during this period, currency levels were flat for 15 years. All of the growth came from expanding bank credit.

But, after that expansion ended, bank credit assumed a less steep trend. This graph from 1974 to present shows both currency and bank credit growing together at a very similar trend of about 2% per quarter. What is surprising is that, despite all the loud protestations about loose money and pretend growth, there was no movement above trend in either of these quantities in the 1990's and early 2000's. It looks likely to me that the slight rise in bank credit after 2006 was a reaction to the sharp curtailment of currency. Households had managed the leverage in their portfolios through the housing boom, so that until the Fed gave the economy one last push off the cliff in 2008 such that even credit markets seized up, households were making up for the currency shortage by tapping their available credit. This ended in late 2008.

I think there are several points of confusion that lead to misinterpretations, several of which I have described before.

1) This strange insistence we have of speaking of monetary policy in terms of interest rate levels.

2) In the late 1990's and early 2000's, there was a large, sustained increase in residential investment, and there was also a rise in home values (which I attribute mostly to low long term interest rates and increasing tax benefits to homeowners). As I have discussed before, because of the way we transact and think about real estate, this causes real estate to increase in nominal value in ways that other assets don't. This is also an asset class that more households tend to follow and be familiar with. Also, people tend to confuse the nominal value of homes with the cost of housing. But, as shown in the second graph above, total consumption of housing was not increasing sharply during this period. And, more than is commonly noted, much of the rise in home values was in equity. Loan to value levels, in aggregate, were pretty steady over this time, and below 50%. The only way that higher nominal values of existing real estate translate into higher nominal economic consumption is through access to credit. If households had seen home values rise another 100%, but didn't take out any more mortgages, then nominal expenditures would not have been affected. Now, it is true that most of the growth in bank credit at the time was in mortgages, but it wasn't enough to push credit above long term trend growth. As seen in the graph above, much of the growth in mortgage credit was countered by a relative decline in industrial credit.

Securitized mortgages not held by banks would also not lead to monetary expansion.

(As an aside, note again in the Fred graph how real estate credit seems to line up with the 1986 and 1996 tax changes. Also, note how there was no relative growth in mortgage levels associated with the additional 2.5% of homeowners between 1994 and 1999. I do think that, these additional home owning households tended to be more highly leveraged than average. But, as I mentioned in the comments of the previous post, these would have been much smaller dollar amounts than average, so even by 1999, when half of the total new growth in homeownership would have already been on the books, it probably added less than 1% to the total mortgage level. That is simply swamped by the other factors that we can see in the graph are moving mortgage levels at a much greater scale. This simply couldn't have scaled up to a quadrupling in mortgage credit and a tripling in home prices. The scale is too small by orders of magnitude. The anecdotal evidence that feeds the notion of the importance of the subprime mortgage market simply doesn't account for the problem of scale.)

3) Corporations massively deleveraged between 1980 and the present. Most growth in corporate values has been in equity. And, as with real estate, this should lead to a need for more currency, since aggregate added enterprise value among corporations has not led to growth in bank deposits.

4) Domestic corporate valuations have not grown as strongly as it seems because of our conventions for tracking their values. First, since the early 1980's, there has been a significant change in capital income distribution, from dividends to buybacks. Both methods have the same effect on the capital base. But, dividends cause stock index values, like the S&P 500 index, to decline, whereas buybacks have no effect on the index level. For the past 30 years, stock market indexes have been overstating growth in corporate capital by about 2% per year. This is a large difference over time. There is growth in the capital base outside of the indexes, from entrepreneurial activity. But, the new tech. firms that have been replacing old capital tend to have low debt levels and hold a lot of cash. This transition from old firms that required a lot of physical capital and utilized a lot of debt to new firms that have little debt and a lot of cash is deflationary, given a stationary currency level.

Secondly, much of the growth in corporate profits and valuations is related to foreign operations, and much of the profit from those operations is being reinvested abroad. This also causes stock valuation indicators to overstate the nominal level of domestic activity, to the casual observer.

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Total credit + currency at the end of 2007 was $7.5 trillion. If it had continued to grow at 8% per year, it would be up to $12.8 trillion. Instead it's at $9.1 trillion. That is nearly 30% below the 70 year trend! This should be extremely deflationary. It suggests, for starters, that if the mortgage credit market remains stuck, the entire quantity of excess reserves could be released as currency without any inflationary effects. I don't think that is actually the case. But the reason it isn't the case isn't because of the currency itself. It's because the currency would probably mostly become equity in real estate, and eventually the added equity would deleverage households enough that mortgages would start to grow, too. But, that is an assumption. If mortgages are mostly stagnant because of an impasse between banks and regulators, then I don't think the new currency would be inflationary.

So, why aren't we experiencing extreme deflation right now? I think the reason is because this has mostly played out through the real estate market. So, first, there are millions of homes that haven't been built over the past decade. The housing stock is probably something like 5% below where we might have expected it to be. That's about 0.5% of real GDP that is just missing. Most of the rest comes through returns to homeowners. Most of that $3.7 trillion in missing money would have been used to bid houses up to their intrinsic values. Because that credit went missing, houses are below their intrinsic values. But, landlords and homeowners are still earning the same rents that they would be earning if the homes were correctly priced. So, unless you need to sell your home, the lost liquidity is not visible to you. In the meantime, institutional investors are buying like crazy to get those excess returns. But, owner-occupier households have been so dominant in the single family residence category for so long - because we used to facilitate mortgage funding - that the organizational foundation for single family home rentals can only grow so quickly.

So, why hasn't this been the case in previous recessions? Look at that first graph. We haven't had a liquidity crisis this bad since the Great Depression. And, since real estate was mostly owned with very little use of credit, the decline in currency filtered through the economy differently than it is today. (Added: The recession of 1990 was associated with a brief deviation from trend that amounted to a permanent decline of nearly 20% in currency and credit. But, inflation was running at 5% when that recession began. And real interest rates were high and risk premiums were low. Yet, with all that going for us, in real terms, home prices declined by 25% by 1996! And nominal interest rates fell sharply - because not only are interest rates a terrible way to judge monetary policy, but to the extent that they are, low long term interest rates are a sign of tight money, not loose!)

Wednesday, February 18, 2015

As far as I can tell, just about everyone agrees on the following series of events:

1) House prices driven up by predatory lenders, or public pressure to expand home ownership, or both, pushed low income households in homes they couldn't afford.

2) As rates rose, low income households with unsustainable ARM mortgages couldn't afford their mortgage payments. Delinquencies started to pile up. Home prices started to collapse as a result of families losing their homes in foreclosures, and the wider economy and labor market finally collapsed under the weight of it.

Let's check this narrative:

1) House prices driven up by predatory lenders, or public pressure to expand home ownership, or both, pushed low income households in homes they couldn't afford.

The first culprit in this step of the plot is the new Community Reinvestment Act of 1994 that is said to have pressured expanding banks to make more loans to marginalized neighborhoods. And, the data suggests that this rule may have been significant in pushing up homeownership rates. Beginning in 1994, there is a marked increase in homeownership rates, which had moved in a tight range around 64% for 10 years.

But, the timing just doesn't fit the story. The ownership rate maxed out at a temporary spike of 69.4% in 2Q 2004. A total rise of 4.3% from the flat trend of 1984-1994. But, half of the rise had already been realized by 4Q 1998, when the ownership rate was at 66.5%. And, as of that point, there had been no rise in inflation adjusted home prices.

Then, between 4Q 1998 and the peak of ownership in 2Q 2004, the Case-Shiller 10 city index rose 86 points.

But, prices didn't peak until 2Q 2006, by which time the Case-Shiller index had risen another 51 points.

So, half of the rise in home ownership came with no effect on home prices, and more than 1/3 of the rise in prices came after home ownership rates peaked. In fact, the steepest period of rising homeownership rates came with no rise in prices and the steepest period of rising prices came with no rise in homeownership rates.

Now, there was a period of 5 years where homeownership rates rose along with home prices. It is certainly plausible that some portion of the rise in prices is related to this portion of homeownership expansion. But, considering there were a total of 6 years before and after that where there was no connection between these trends at all, the proportion of the price movement related to pressing marginal first-time homeowners into questionable mortgages is highly suspect.

I would have even believed very easily that desperate mortgage brokers might have been bottom feeding to keep their business plans intact as the boom stalled. But, even that notion is betrayed by the data. No net marginal households were purchasing homes for two entire years before prices peaked.

I would like to make two more points here, also.

First, we are talking about a rise in homeownership from 64% to 69%. Or, put conversely, the marginal non-homeowning household at the beginning of the period was at the 36%, and by the peak, was at the 31%. This is a marginal change. While I don't doubt that many anecdotes about reckless mortgage brokers are true, the notion that the boom was built on wide-spread new ownership by households far outside the typical range of home-owning households doesn't seem to pass the smell test. In 2011, the 36th percentile household income was about $35,000 and the 31st percentile household income was just over $30,000. Households don't line up cleanly by income to be the marginal homebuyer, but this gives a sense of scale regarding the relative incomes associated with this expansion of households.

Secondly, between 1994 and 1999, about 3 million marginal households (on net) became home owners. Those households experienced extremely profitable gains on their new homes. Even today, their aggregate home values are more than double what they were at the times of their purchases. For half of the new marginal home owners, homeownership was an extremely profitable decision. I wonder if there are any stories in the Washington Post where these homeowners gush about what a great service their bankers provided for them.

In fact, today's housing price level is higher than the price level was in 2004 when the last net marginal household became a homeowner. And, except for the last 1% of net marginal owners in the last year before the peak, aggregate nominal home prices never declined below the level at the time of the original purchase.

2) As rates rose, low income households with unsustainable ARM mortgages couldn't afford their mortgage payments. Delinquencies started to pile up. Home prices started to collapse as a result of families losing their homes in foreclosures, and the wider economy and labor market finally collapsed under the weight of it.

Well, wait a minute. The homeownership rate topped out because ARM mortgage rates started to rise, causing borrowers to default on unsustainable mortgages. Right?

Here is a graph of the Fed Funds Rate and the Real Estate Delinquency Rate.....

Short term rates began to rise in 2Q 2004, topped out in 3Q 2006, and remained there until 2Q 2007.In 2Q 2007, the single family home delinquency rate was at 2.3%. Please note how starkly the consensus narrative differs from reality.

In 2Q 2007, at 2.3%, single family home delinquency rates were still at the level we saw throughout the 1990's, which ranged between 2% and 3.4%. Short term interest rates had been rising for 3 years and had been at this level for 1 year, so rate resets would have been well-baked in by this time.

At this point, the relationship between single family home delinquencies and interest rates was typical. In 2Q 2000, the yield curve inverted, and delinquencies began to rise. By 2Q 2001 delinquencies hit 2.4% and leveled out. In 1Q 1989, the yield curve inverted, and delinquencies began to rise. By 4Q 1990, they topped out at 3.4%.

In 2007, at the supposed end of the biggest, baddest housing bubble since the tulip craze of 1637, at the end of the rate tightening cycle, the delinquency rate was 2.3%. By 3Q 2007, both the Fed Funds Rate and long term rates were in free-fall. There is no question that by this time, the liquidity crunch was in full swing.

Home prices were still near their peak at this point. Homeownership rates were down to 68.3%. Home prices, even now, were 44% higher than they had been in 3Q 2003, when homeownership had last been 68.3%. Can we attribute home prices in 2Q 2007 to loose monetary policy, a year into the yield curve inversion, and on the cusp of a demand collapse?

The next few graphs looks pretty clear to me. Note that in the rates & delinquencies graph, the home price index is inverted to help see the parallels in the trends. I have also added unemployment, which bottomed in 4Q 2006, after the yield curve inverted - just like it had in 1989 and 2000. In 4Q 2006, when unemployment bottomed, delinquencies were at 2.0% and home prices were still at their peak.

So, the consensus narrative is that loose money, greedy bankers, and enthusiastic bureaucrats combined to create a housing bubble. Despite these policies, the unsustainability of dicey mortgages caused millions of households to default because they couldn't keep up with rising rates, and this led to the crash of the bubble, despite efforts by the Fed to prop up this pretend economy.

In the 18 months after 2Q 2007, to 4Q 2008, home prices dropped by 25%! In those 18 months, delinquencies rose from 2.3% to 6.9%. Unemployment also rose to 6.9%. In the following year, while home prices would find their bottom, unemployment would top out at about 10%. Soon after, delinquencies on single family homes would top out at 11.3%

Here is one last graph, comparing delinquencies on single family homes, all real estate loans, and all loans at commercial banks. We don't see delinquencies on single family homes rising, leading to problems in other areas. We see all three measures rising at once, as if moved by some singular exterior force. The only difference in behavior is after 2010, when policies regarding bank regulation, foreclosure processes, continued timid monetary policy, and persistent unemployment continue to create frictions in the owner-occupier home market. Again, the problems distinct to single family homes are, if anything, the lagging factor.

Two last graphs. This is a graph of currency and bank credit. Currency began to fall from trend as early as 2003 & 2004. This might be reasonable because households were sitting on a lot of home equity, although total bank credit was not outside the typical range of its long term trend in the 2000s. And, nominal home values had topped out by the end of 2005. But, currency continued to fall from trend until late 2008. The rise in bank credit doesn't line up with the housing boom. It looks to me like it is more of a reaction to the Fed's tight money policy at the end of the housing boom. Household equity % had been steady for a decade, and had been growing since 2003. Home prices topped out at the end of 2005, and homeowner's equity began to fall precipitously while home prices held steady. At this point, after currency had been growing at 8% annually for decades, it was now growing at less than 3%. At this point, households were desperate for liquidity. They had held equity steady throughout the boom. In early 2006, they were done bidding on real estate, but they were desperate for cash. This was happening by 1Q 2006. As late as April 2008 - more than two years after this clamoring for liquidity began - the Fed had pushed the YOY change in currency down to 0.6%!

Even in early 2008, after 2 years of liquidity starvation and home prices down 15%, delinquencies were under 4%. Yet, after all of this, in the infamous September 2008 FOMC meeting, the Fed held rates steady to signal that inflation was their primary concern. They soon dropped rates to the zero lower bound. Delinquencies in 3Q 2008 were still at 5.2%. Two-thirds of the rise in delinquencies happened after that meeting, with short term rates (presumably including ARM rates) near their lower bound. However, equity as a proportion of real estate began rising again in 1Q 2009, when the Fed finally reversed course and implemented QE1.

Tuesday, February 17, 2015

I described mortgages as a sort of planned savings program. The mortgage payment includes an inflation premium. All else equal, in the typical year, in aggregate, real estate should appreciate by roughly the rate of inflation, which increases the owner's equity. In addition, a homeowner pays some principal on the mortgage amount. The homeowner also pays interest on the mortgage. The real part of the interest is a cost-of-capital payment to the lender. The inflation premium portion of the interest payment is really another portion of the homeowner's equity accumulation, because the mortgage principal remains fixed in nominal terms, which means that it declines in real terms.

Neither the increase in the home's market value nor the inflation portion of the mortgage payment are generally treated as household savings, which is one reason why much of the data and discourse about household savings is non-informative.

In the early 1980's, effective aggregate mortgage rates hit 10% (7% inflation premium + 3% real) and mortgages amounted to about 30% of GDP. By the late-1990's, before the housing boom, the effective average mortgage rate was down to 7% (3% inflation premium + 4% real) and mortgages amounted to about 43% of GDP.

In the 1980s, until about 1989, homes were gaining about 7% in nominal value, annually. But, prices topped out, and for the next decade, nominal home values were stagnant. Aggregate owner-occupied home values were roughly equal in value to annual GDP during this period, coincidentally.

So, with regard to home owning households that aren't engaged in real estate transactions or active re-leveraging, in the 1980's, households were saving about 9% of GDP each year (7%*30% + 7%). But, in the 1990's, households were only saving 1.3% of GDP (3%*43% + 0%). in expected terms, in the 1980's households were saving 2% of GDP (7%*30%) and in the 1990's they were saving 1.3% (3%*43%). In actual terms, 1980's households were saving 7% and 1990's were not saving anything beyond their principal payments. (edit: sorry. My original version double-counted by confusing expected returns with actual returns.) This was a huge shift in household financial behavior. And, it happened without any conscious change in savings behavior!

This passive shift in saving behavior should put upward or downward pressure on the level of mortgages. I believe we can see the basic expected effects of this process in the historical data. Compared to what we might expect, shifts in mortgage and equity levels are unusually high in the 1980s and 1990s because of tax changes and unusually low in the 2010s because of the liquidity crisis.

This passive saving issue should have a significant effect on monetary policy. The inflation rate has little effect on lenders. Their capital base will grow at the real interest rate regardless of inflation. But, inflation does have a significant effect on homeowner behavior. This is largely passive savings which households treat as deferred consumption. As they pay down their mortgages, unless banks reallocate capital into new mortgages or other sectors, there would be a decline in bank credit outstanding.

Because owner-occupied home equity is tax advantaged, there is no tax arbitrage advantage for households to re-leverage. And the additional equity has very little effect on consumption. So, in real estate, there is probably a mitigating downward influence on aggregate demand when inflation rates are high.

The same concept can be applied to corporate debt

The inflation premium is a sort of pre-planned savings for corporate debt, too. In fact, the inflation premium on corporate debt is like the debt equivalent of share buybacks. In both cases, some portion of nominal earnings is used to repurchase some portion of the claim on future profits, and remaining shareholders have a higher ownership share in the firm's operations, which is manifest through unrealized capital gains.

There is a difference between corporate and real estate debt, though. Whereas owner-occupied real estate confers several tax advantages to the owner, whether ownership is weighted to debt or equity funding, corporations have a clear tax advantage to debt-based funding. This is especially true in high inflation (high interest rate) contexts. So, where households would tend to accumulate equity in a passive asset for deferred consumption, corporations would tend to re-leverage as the real level of debt decreases through inflation.

I think we can see this difference in the comparison between the late 1970's and the 2000's. In both cases, real risk free interest rates were very low and risk premiums were high, which would tend to pull capital out of corporate equities, into real estate and corporate debt. However, inflation premiums were high in the 1970's and low in the 2000's. Because of the different effects of the inflation premium, outlined above, this would tend to pull capital into corporate debt in the 1970's. But, in the 2000's the low inflation would keep corporate interest rates low, reducing the incentive for corporate debt, and leading to more capital being allocated to real estate (both equity and debt) and, to a lesser extent, corporate equity ownership.

Further, because the passive savings from the high inflation premium is so strong, I wonder if the low real rates of the late 1970's were, in large part, caused by the high inflation. In the 2000's, I have assumed that the low real interest rates were a result of excess savings coming out of demographics and developing economies. But, as I walk through this topic, I am starting to think that the low real interest rates of the 2000's were exacerbated by tax policies in housing that have pulled so much household capital into real estate and pushed down pre-tax required real rates of return in so much of the single family home market. (Note how many articles there are complaining about low distribution of stock ownership among households, and how little emphasis is given to housing tax incentives as a cause. And, how often is the solution redistribution through higher taxes on capital income and high compensation income? I have posed this question before. When these taxes induce even more household capital into the tax-preferred deferred consumption of home-ownership, what would be the effect on the breadth of stock ownership and the long term employment and productivity of middle income workers? Of course, then we will see more articles about how high house prices and low industrial employment are squeezing the middle class.)

At the other end of the business cycle, the 1990's were economically strong - strong wage and capital income. Low equity risk premiums, falling inflation, and high real interest rates were associated with stagnation in real estate capital levels and a boom in corporate capital, concentrated in equity. This is just as we should expect. Note from the graph above that dividend yields were low in both the 1960's and 1990's. A lot of unnecessary gravitas is usually ascribed to corporate payout ratios. But, looking at this through a risk-trading paradigm, in those periods, corporate equity would have been attracting capital, and most corporations would find themselves under-allocated to equity compared to the optimal level. Lowering the payout ratio would be the most efficient way of approaching the optimal allocation.

PS: There are a lot of ideas floating around here, so I apologize if this series is occasionally scattershot or repetitive.

PPS: I start to wonder if, at some point, some readers start to think something along the lines of, "Well, duh. He's just talking about what Sanchez and McGillicuddy worked out in their seminal 1995 paper." Or worse, "Uh. I thought Sanchez and McGillicuddy put an end to this sort of misinformed nonsense with their seminal 1995 paper." Either way, when you think that, please give me a reading reference in the comments.

Thursday, February 12, 2015

I used data from the BEA table 7.12 on rent income and mortgage interest expense, along with data from the Fed's Flow of Funds report on real estate values and mortgage levels, nonfinancial corporate income, interest expense, and equity and debt levels. From these data, I can create estimates of aggregate effective interest rates and rates of return and compare levels of various asset classes. I am looking at five asset classes, listed roughly in order from least to more risky:

Treasuries

Mortgages

Home Equity

Corporate Debt

Corporate Equity

Over the long term, all but the owner-occupied home equity market are highly sophisticated and liquid markets, which should lead to arbitraged risk-adjusted, after-tax returns. And, even though owner-occupied home equity does not share characteristics such as easy diversification, it appears to also tend toward no-arbitrage, risk-adjusted, price parity with the other asset classes. So, changes in the relative prices of these assets should reflect changing risk attitudes, expectations, and tax rates. In other words, the supply elasticity with these assets is very high with regard to substitutions of investors between the asset types.

So, for instance, I am considering the effect of tax changes on mortgages. But, in terms of mortgage interest rates, the tax treatment of the lender will be the overwhelming influence on mortgage interest rates. Whereas lenders are allocating a given capital base among these securities based on after-tax, risk-adjusted returns, mortgage borrowers are not allocating a given amount of debt among asset classes. The mortgage level and rate they accept will be filtered through many factors, such as the size of the home, the amount of leverage used, etc. So, tax treatment of the borrower will tend to affect quantities, while the interest rates on mortgages will reflect supply.

(One possible exception is that some of the split of returns on homes between the equity holder and the lender reflects duration exposure on the part of the homeowner. After mortgages gained tax benefits, home owners might choose to accept more duration on the mortgage, since the after-tax premium on duration would be lower. So effective rates would be higher, as a result of the changing risk exposure of the owner. This effect is probably swamped by other effects.)

There have been changes in interest rate spreads over time, which I think do point to effects from the changing tax treatment of housing capital.

This first graph compares treasury, corporate, and housing returns over time. (I have used the implied inflation rate from my effective mortgage rate figure to adjust corporate and treasury rates. I know this isn't perfect, but I think it is better than using inflation or survey data. In any case, all three methods give similar results for time-series analysis.) Because of stickiness in housing markets and the very long duration of homes, effective home returns are more stable than corporate or treasury debt. But, we can see that returns to housing have, more or less, tracked trends in treasury rates. However, beginning in the mid-1960's (when the housing agencies were consolidated into HUD, and there was a build up in home equity ownership), corporate debt started to require higher spreads. Then, the corporate spread really took off in the mid-1980's, when the mortgage deduction attained tax value.

This regime shift is very clear in this next graph that shows the effective corporate interest rate from Flow of Funds minus the 10 year treasury rate. There is a jump of 1% from the 1960s to the 1970s, then, after 1986, a jump of 2%.

This is evident in this Fred graph comparing spreads, too. Mortgages have remained in a range of 1% to 2% above 10 year treasuries. But, Aaa corporate spreads before 1986 ranged from 0% to 1%, and since then have ranged from 1% to 2%. The Baa spread has followed a similar pattern.

In the next graph, I have used the income information from BEA table 7.12 to compare pre-tax returns on owner-occupier homes to rented homes. I don't have aggregate market value information that matches with these rented homes, so I used the capital consumption figure from table 7.12 as a proxy for home value. And, what we find is that until 1986, owner-occupiers earned a consistent premium over renters.

This is a little difficult to work out. I hope to tie together all of these factors by the end of the series. But for now, I will simply note the intuition that if savers are arbitraging after-tax returns, then pre-tax returns for owner-occupiers would decline as they attained tax-preferred treatment. So, this result should be expected, as far as that goes. But, to be honest, I haven't fully put this all together.

Since 2007, credit markets have shut down in owner-occupied real estate and implied returns on homes have shot up. In the graph comparing landlord income and owner-occupier income, my proxy for home values breaks down after 2007 because of the disequilibrium in this market. The implied return for owner-occupiers follows a similar trajectory to landlords if we use home market values instead of consumption of capital as the denominator. That is because many homeowners are sitting on homes that have seen marked declines in nominal value. This problem doesn't affect landlords as much because so many of the landlord properties have been purchased in the cash market during the recent slump, resetting the depreciation at a lower level. So, returns to home ownership are very high, but mortgage spreads have moved along about where they have been.

I think what we are seeing in these changing spreads is related to the effects of these tax changes. As tax incentives pull more capital into housing, mortgages and homes are commanding a higher proportion of capital, and home equity is also providing additional returns from liquidity and non-diversification risk. The advantages to these real estate securities are pricing corporate securities out of both the low-risk space and the high-risk space. So we are seeing a decline in the quantity of corporate investments, less reliance by corporations on debt, and higher premiums paid for both corporate debt and equity, relative to risk-free rates.

Note that Commercial and Industrial Loans moved along at 32% to 40% of bank credit for decades, until the mid-1980s, when they suddenly began a long term decline. And, note the sharp increases in real estate credit, after 1986 and 1996. Now that real estate is not taking in new capital, commercial credit is pushing up above its previous peak.

Maybe the causation runs both ways here. Low risk free rates have pushed home prices up. But, possibly current risk premiums themselves are a product of housing tax policy, to an extent. I have previously suggested that the significant reductions in corporate leverage over the past 30 years has been a result of corporate capital management under falling nominal interest rates. This housing analysis suggests that the lower corporate leverage has come from a kind of crowding out. But, all of these trends are probably inter-related.

Further, there is the oddity that, given the shifts in capital allocation outlined above, corporate enterprise value (equity + debt) has not declined as a portion of GDP. (This graph is of non-financial corporate enterprise value, adjusted to domestic levels by using proportion of foreign profits, as a share of GDP. It shows some rise over time, but this is generally due to the transfer of assets from proprietorships to corporate ownership over time.)

What does this mean? Well, we must remember that housing values are anchored in rent levels. So, when price/rent levels rise, housing expenses remain basically the same, but nominal prices of houses rise. Prices have risen because interest rates have declined, and I believe that they also have risen because of these tax incentives. To the extent that the increase in owner-occupied housing stock (see the fifth graph above) has increased as a percentage of GDP, what we are seeing is the nominal value of the tax transfers from renters to owner-occupiers. Owner-occupiers are, in effect, expressing the value of these tax incentives through higher nominal home values.

I'm not sure that any of this has much effect on the non-housing economy. In nominal terms, it makes it look like there is a lot more debt and capital than there used to be. But, housing capital is kind of funny. It kind of feeds itself because the higher values lead to credit creation. If we didn't have all of this extra nominal real estate capital, the non-real estate economy would still operate just as well. It would just need a little more currency to keep everything moving, to make up for the lost home equity that currently serves as a savings vehicle. I think the largest effect might be that real incomes of renters are being decreased by these policies. They are being taxed through their landlords, via higher rents.